In its first year of operations Tower Ltd purchased and paid for widgets costing $50,000. During
that year Tower Ltd sold 60 per cent of the widgets. The widgets on hand at the end of the year
cost $20,000. The sales were on credit terms. Tower Ltd received $37,000 in cash from
customers and $3,000 remained uncollected at the end of the year. During the last quarter of the
year of operations Tower Ltd entered into a property insurance contract for losses arising from
fire or theft. The annual premium of $4,000 was paid in cash and the insurance expired nine
months after the end of the reporting period.
Calculate Tower Ltd’s profit for the first year of operations on an accrual basis and on a
cash basis. Explain the difference between the two measures. Which of the two profit
measures is more useful for assessing Tower Ltd’s performance during its first year of
operations? Give reasons for your answer.
Accrual base: income earned 40,000- cost of item 30,000-(4,000*3/12)=9,000
Cash base: cash received 37,000- cost of item 30,000- insurance 4,000=3,000
To calculate Tower Ltd's profit for the first year of operations on an accrual basis and on a cash basis, we need to consider the revenues and expenses for the year.
Accrual basis profit:
1. Calculate the cost of goods sold (COGS) by multiplying the cost of widgets purchased ($50,000) by the percentage sold (60%): $50,000 * 60% = $30,000.
2. Calculate the gross profit by subtracting COGS from the total sales: Total sales - COGS = $50,000 - $30,000 = $20,000.
3. Deduct any uncollected sales (accounts receivable) from the gross profit: $20,000 - $3,000 = $17,000.
4. Subtract any other expenses, such as the insurance premium: $17,000 - $4,000 = $13,000.
5. The profit on an accrual basis is $13,000.
Cash basis profit:
1. Calculate the cash received from customers: $37,000.
2. Deduct any uncollected sales (accounts receivable): $37,000 - $3,000 = $34,000.
3. Deduct any expenses paid in cash, such as the insurance premium: $34,000 - $4,000 = $30,000.
4. The profit on a cash basis is $30,000.
The difference between the two measures lies in the timing of when revenues and expenses are recognized.
Accrual basis measures profit by recognizing revenues when they are earned and matching them with the expenses incurred to generate those revenues, regardless of when the cash is received or paid. It takes into account accounts receivable (revenue not collected) and accounts payable (expenses not yet paid).
Cash basis measures profit by recognizing revenues when cash is received and expenses when cash is paid. It does not consider accounts receivable or accounts payable.
The accrual basis of accounting is generally considered more useful for assessing a company's performance as it provides a more accurate picture of the company's financial health. It matches the revenue earned with the expenses incurred during a specific period, allowing for better analysis and decision-making. Cash basis can be misleading as it does not consider the timing of cash flows and can distort the financial results, especially in cases where there are significant accounts receivable or accounts payable balances.
To calculate Tower Ltd's profit for the first year of operations on an accrual basis, we need to consider the revenue and expenses that occurred within the reporting period, regardless of when the cash was received or paid. On the other hand, to calculate profit on a cash basis, we only consider the actual cash inflows and outflows during the reporting period.
Let's break down the calculations for each profit measure:
Accrual Basis:
1. Revenue: Tower Ltd sold 60% of the widgets and received $37,000 in cash and $3,000 remained uncollected. So, the total revenue would be 60% of ($37,000 + $3,000) = $24,000.
2. Cost of Goods Sold: Tower Ltd purchased widgets costing $50,000 and had $20,000 worth of widgets remaining at the end. So, the cost of goods sold would be $50,000 - $20,000 = $30,000.
3. Expenses: There are no expenses mentioned in the information provided.
4. Profit: Revenue - Cost of Goods Sold = $24,000 - $30,000 = -$6,000 (Loss)
Cash Basis:
1. Cash Inflows: Tower Ltd received $37,000 in cash from customers.
2. Cash Outflows: Tower Ltd paid $50,000 for purchasing widgets and $4,000 for insurance premiums.
3. Profit: Cash Inflows - Cash Outflows = $37,000 - $50,000 - $4,000 = -$17,000 (Loss)
The difference between the two profit measures is primarily due to the timing of cash flows and the concept of accrual accounting. Accrual basis takes into account revenue and expenses when they are earned or incurred, regardless of the cash flow timing. Cash basis, on the other hand, only considers the actual cash inflows and outflows.
In the case of Tower Ltd, the accrual basis shows a loss of $6,000 because the revenue recognized (based on selling the widgets) is less than the cost of goods sold. However, on a cash basis, the loss is higher at $17,000 because the cash outflows (purchase of widgets and insurance premiums) exceed the cash inflows from customer payments.
When assessing Tower Ltd's performance during its first year of operations, the accrual basis profit measure is considered more useful. Accrual accounting provides a more accurate reflection of the financial health and performance of a business as it recognizes revenue and expenses when they occur, rather than when cash is received or paid. The accrual basis profit measure gives a better indication of the company's ability to generate revenue and manage expenses in the long run, whereas cash basis profit can be distorted by temporary cash flow fluctuations.